Issue 109:2017 06 15:So What? (Adam McCormack)

15 June 2017

So What?

Markets may be wrong in their initial reaction to a hung parliament

by Frank O’Nomics

When economic historians of the twenty-first century come to assess the impact of key events on bond and equity market charts they will struggle to pinpoint the 2017 general election.  Beyond a reaction in the currency markets (and sterling is still way above the levels hit earlier in the year) markets barely skipped a beat on the news of a hung parliament.  The events of last year, when the initial sell-off on the Brexit vote proved to be very brief, left most participants wary of taking a negative view that might leave them struggling to get back into a rising market.  There are a number of reasons to justify this relaxed approach, but the outlook does not look encouraging.  Inertia may not be a standard ‘knee-jerk” reaction, but it may prove just as mistaken as the brief sell-off last summer.

Let’s look first at why positive market analysts might argue that the election is largely an irrelevance.  Set against much more seismic events like our decision to leave the EU and the US electorate’s favouring Donald Trump, a UK hung parliament is undoubtedly much less important.  Given that it seems unlikely that the Labour Party will end up forming a government there is little likelihood of any significant change in policy and for most it will be business as usual for now.  Indeed, given that any deal with the DUP is likely to feature anti-austerity measures of increased spending on roads and infrastructure as well as defence spending, the election may be perceived as supportive for the economy.

From a market positioning point-of-view, there is also little to prompt a sharp response.  The election result was negative for sterling, but many participants are already underweight and are unlikely to want to add to positions given a potential increase in volatility. Similarly, given that most UK equities have substantial $ earnings, the impact of a weak currency on FTSE in particular is very limited, and those with a focus on exports will benefit from becoming more competitive.  Without winning the clearer mandate for a potentially hard Brexit, a softer outcome now seems more likely and this too could reassure some UK companies.

Why then is there any cause for concern? Perhaps the key issue is that the increased level of uncertainty has occurred at a time when the economy was already started to slow markedly.  Consumer spending in May was 0.8% lower than the same month last year, representing the first year-on-year fall since 2013, with retail sales in Q1 showing their biggest fall since 2010 and industrial production rising just 0.2% in April, when economists had been expecting 0.8%.  The UK was the weakest performer in the G7 in Q1, and a 1.9% fall last month in retail sales will not have helped.  The election outcome is not going to help turn around confidence in either households or businesses, leaving the growth outlook continuing to weaken.  Optimists will argue that the continuing high employment and low interest rate backdrop will allow confidence to rebuild, but there are threats here also.  Inflation has picked up to 2.9% this week (2.7% was the level expected by economists), which is the highest level for four years.  Any further pressure on the currency will add to this and, while the Bank of England is not likely to react by putting up rates for now, it is unlikely that they will feel empowered to help counter an economic slowdown with a rate cut or more quantitative easing.  It was these measures that helped reassure markets in the aftermath of the Brexit vote and this is a prop that cannot be relied upon this time around.  The impact of inflation on consumer spending is already being felt and will be compounded by low wage growth, which, according to the Resolution Foundation this week, leaves real incomes falling by around 0.5%.

Perhaps the bottom line in this discussion is that we are still leaving the EU, but our negotiating position has been undermined by the lack, for an indeterminate period, of a stable government.  Many will be reassured that this implies a stronger chance of a softer Brexit, but the pace of the process will be difficult to arrest.  Talks with the EU commence on 19th June and, unless we agree a delay (which would seem unlikely), the chances of being given a “take it or leave it” offer would appear to have increased in the last week.  Markets are faced then with the prospect of extended uncertainty but with a greater chance of a less favourable outcome.

What then are the investment implications of all of this?  Perhaps the biggest negatives are for UK bonds.  Higher (currency induced) inflation, together with increased borrowing as the tax take falls due a weaker economy and the inability to enact austerity measures, all point to higher long term borrowing costs.  In addition, the UK is highly reliant on overseas investors buying government debt (they currently own 27% of the gilt market) and there is not only a risk that they stop buying, but also that they start to reduce their current holdings. While higher long-term rates may help pension funds, they will have a negative impact on mortgages and credit in general. Equities may be more insulated given their overseas earnings, but will look less attractive on a relative basis if gilt prices fall.

In terms of what might look more attractive, European markets could be well worth exploring.  To some extent investors have already bought into this view, with European equities up around 18% year-to-date, which is around twice the return of the UK (in dollar terms). The main factors discouraging investment in Europe had surrounded electoral uncertainty, with most of this now successfully negotiated, the recent impressive progress in European economic data makes the area look increasingly attractive.

For now the state of market inertia in the UK looks set to persist.  Arguments that uncertainty will ultimately undermine asset prices have been valid for a long time; yet have failed to have any effect thus far.  Those sanguine investors who look beyond political factors that are impossible to predict and instead focus on areas where they perceive long-term value may well be justified.  However, with earnings valuations at demanding levels (and a record 44% of investment managers surveyed by Bank of America this week think that UK equities are overvalued) they may well have a very uncomfortable run through Brexit negotiations, and increasing one’s geographical investment diversity could be prudent.


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